Lecture No. 5 (MGT411)Banking

Financial Intermediaries

The informal arrangements that were the mainstay of the financial system centuries ago have since given way to the formal financial instruments of the modern world Today, the international financial system exists to facilitate the design, sale, and exchange of a broad set of contracts with a very specific set of characteristics. We obtain the financial resources we need from this system in two ways: Directly from lenders and Indirectly from financial institutions called financial intermediaries  Indirect Finance   A financial institution (like a bank) borrows from the lender and then provides funds to the borrower. If someone borrows money to buy a car, the car becomes his or her asset and the loan a liability. Direct Finance   Borrowers sell securities directly to lenders in the financial markets. Governments and corporations finance their activities this way The securities become assets to the lenders who buy them and liabilities to the borrower who sells them Financial and Economic Development   Financial development is inextricably linked to economic growth There aren’t any rich countries that have very low levels of financial development. Figure: Financial and Economic Development    Financial Development is measured by the commonly used ratio of broadly defined money to GDP. Economic development is measured by the real GDP per capita. Financial Instruments   A financial instrument is the written legal obligation of one party to transfer something of value – usually money – to another party at some future date, under certain conditions, such as stocks, loans, or insurance. Written legal obligation means that it is subject to government enforcement; The enforceability of the obligation is an important feature of a financial instrument. The “party” referred to can be a person, company, or government The future date can be specified or can be when some event occurs Financial instruments generally specify a number of possible contingencies under which one party is required to make a payment to another Stocks, loans, and insurance are all examples of financial instruments Uses of Financial Instruments     Means of Payment Purchase of Goods or Services Store of Value Transfer of Purchasing Power into the future Transfer of Risk Transfer of risk from one person or company to another   Characteristics of Financial Instruments     Standardization Standardized agreements are used in order to overcome the potential costs of complexity Because of standardization, most of the financial instruments that we encounter on a day-to-day basis are very homogeneous Communicate Information Summarize certain essential information about the issuer Designed to handle the problem of “asymmetric information”, Borrowers have some information that they don’t disclose to lenders Classes of Financial Instruments   Underlying Instruments (Primary or Primitive Securities) E.g. Stocks and bonds Derivative Instruments Value and payoffs are “derived from” the behavior of the underlying instruments Futures and options Value of Financial Instruments   Size of the promised payment People will pay more for an instrument that obligates the issuer to pay the holder a greater sum. The bigger the size of the promised payment, the more valuable the financial instrument When the payment will be received The sooner the payment is made the more valuable is the promise to make it The likelihood the payment will be made (risk). The more likely it is that the payment will be made, the more valuable the financial instrument The conditions under which the payment will be made Payments that are made when we need them most are more valuable than other payments Value of Financial Instruments Size Payments that are larger are more valuable Timing Payments that are made sooner are more valuable Likelihood Payments that are more likely to be made are more valuable Circumstances Payments that are made when we need them most are more valuable